This is the ‘bad’ kind of dollar weakness

That’s especially the case when it comes to movements by the U.S. dollar. When the currency is on the rise as frightened investors scramble for safety—think 2008 and the global financial crisis—stocks and other risky assets suffer. In other circumstances, such as when the dollar is rising alongside two-year Treasury yields in response to strengthening economic fundamentals, stock returns tend to be positive.

It’s a similar story when the dollar is weakening. Steve Barrow, head of G-10 strategy at Standard Bank, argued in a Monday note that the dollar’s recent performance, which has featured a fall against the yen and the euro but a pretty restrained decline against other currencies marks a “bad” fall in the dollar, “namely one that is bringing with it a sharp rise in risk aversion.”

“Bad” dollar weakness contrasts with “good” dollar weakness, which is what had previously prevailed as the dollar declined against many so-called risk currencies as well as its major rivals.

Barrow elaborates on the distinction:

What determines good and bad dollar weakness? The answer would seem to be down to whether the slide is being generated by angst in the US. Very often in the past the dollar has tended to strengthen if bad things happen in the US. Developments such as the financial crisis or US military action abroad have usually bought with them safe-haven demand for the dollar that has lifted the greenback against ‘riskier’ currencies such as those in emerging markets, if not ‘safer’ currencies such as the yen and the Swiss franc.

But right now the ‘bad’ news relating to the difficult start to the presidency for Donald Trump seems to be weighing on the dollar. However it is weighing on the dollar against other ‘safe’ currencies such as the euro, yen and Swiss franc, not the ‘riskier’ currencies in the developed world or many emerging market currencies.

The euro is up more than 3% versus the dollar since the end of April, while the U.S. unit has declined 4.9% versus the yen over the same period. The more risk-oriented Australian dollar
AUDUSD, +0.1532%
, by contrast, is off around 0.2% versus its U.S. counterpart in the month to date.

Barrow doesn’t expect the pattern to change, calling for rising political angst in the U.S. to pull the dollar down against the likes of the euro
EURUSD, +0.3169%
, Japanese yen
USDJPY, -0.11%
and Swiss franc
USDCHF, -0.0403%
while leaving it stable, “or even stronger,” against many riskier developed and emerging market currencies.

Part of the rationale centers on elevated asset prices, “such as developed-country equities and perhaps especially those in the U.S.,” Barrow said. “If dollar weakness goes hand in hand with crumbling stocks we’re likely to see the dollar rise against risk currencies even if it stumbles against the ‘safe’ currencies,” he said.

Barrow’s base case is for the dollar to continue its “somewhat bipolar” pattern, with weakness against other safe currencies partly offset by stability or even strength elsewhere. That should translate into further dollar weakness in the broadest trade-weighted terms given the weights of the euro, yen and even the Chinese yuan, he said.

The ICE U.S. Dollar Index
DXY, -0.36%
, a measure of the U.S. unit against a basket of six major rivals, could also retreat to the 90 region, which is consistent with Standard Bank’s call for the euro to push on to $1.15 over the summer, he said (over the next few years, Standard Bank sees the euro potentially testing $1.40). The index was off 0.2% at 96.978 on Monday and is down more than 2% for May.

But what if the dollar were to suddenly rebound in response to the evaporation of U.S. political fears or other factors, such as quick progress on tax cuts or a more aggressive-than-expected tightening by the Federal Reserve? It depends on the driver, Barrow said.

An aggressive Fed, for instance, would hurt risk currencies the most, he said. But until something happens, it’s appropriate to focus on dollar weakness “while being acutely aware which currencies are likely to strengthen against the dollar and which ones might be left behind.”

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